Description

Highland Floating Rate Opportunities Fund (HFRO) is a closed end fund selling at a 5% premium to its Net Asset Value.  Normally this would be grounds for a short sale recommendation.  However, HFRO is in the final stage of a litigation contest that is likely to materially increase its value in a relatively short period of time.

History

In 2007, Claymore Holdings, a division of Highland Capital Management, invested $250 million through the Highland Floating Rate Opportunities Fund and the NexPoint Credit Strategies Fund to refinance Lake Las Vegas, a 3,600-acre residential and resort development that filed for bankruptcy in 2008. Credit Suisse acted as the administrative agent for the refinancing deal.

Claymore sued Credit Suisse in Texas District Court in Dallas in 2013, alleging the firm "manipulated the appraisal to inflate the value of the property," citing the loss of the entire $250 million investment "because of Credit Suisse's fraud and breach of contract". 

In a jury trial in 2015, Claymore Holdings was awarded $40 million in damages in relation to the fraud charge.  In response to Claymore’s breach of contract claims, the trial judge increased the award to $212 million in damages and $75 million in prejudgment interest as well as court costs and post-judgment interest. Post judgment interest in Texas accrues at 9% per year.

Credit Suisse appealed, arguing that a) that Credit Suisse, in its role as agent had no duty to Claymore with regards to the accuracy of the appraisal, and b) the trial judge had no right to increase the jury award.  The appellate court disagreed, and issued a ruling affirming the jury’s decision on the facts and the trial judge’s decision on the amount of damages. This ruling was issued on February 20th. Credit Suisse filed a motion for rehearing on March 7^th.  This motion was denied on April 2^nd.   The next step for Credit Suisse will be to appeal to the Texas Supreme Court.  This must be done within 45 days (mid-May).   I believe it is unlikely that the Texas Supreme Court will decide to hear this case.

As of February 20, 2018 the award had increased to $351 million, of which $289 million would go to HFRO, and $62 million would go to NexPoint.

HFRO currently has 71.7 million shares outstanding, so the award (before legal fees) represents approximately $4.00 per share, or roughly 25% of HFRO’s current market value.

The table below shows the expected return assuming the litigation is resolved by the end of 2018. I have assumed a 10% haircut for litigation expense and that HFRO trades at a 10% discount to NAV.  HFRO is currently paying $.077 per month in dividends.

Risks

HFRO mainly invests in low grade, illiquid securities.

While most assets are floating rate, there is likely to be a lag between increases in market interest rates and resets on HFRO’s investments.

Litigation always takes longer than I expect.

Note:

If you are interested in HFRO, you may want to take a look at NexPoint Strategic Opportunities Fund (NHF).  NHF’s stake in the litigation is around 10% of NAV, but NHF is selling at a 10% discount.  NHF’s portfolio is over 50% in equities.

Catalyst

Appeal to the Texas Supreme Court - likely to be rejected some time this year.